New Home Sales: Better but Still Historically Weak

24 March 2015

by SAMI KARAM

New home sales for February were stronger than expected, at an annualized pace of 539,000 units vs. 465,000 expected. This is good news because it is the highest number since early 2008. However, the chart below shows that we are still dealing with a depressed single-family housing market.

Screen Shot 2015-03-24 at 10.30.11 AM (2)

First, it is clear that we are very far below the peak recorded near 1.4 million in the mid-2000s. Second, if we dismiss that period as an irrational bubble, it is still a fact that a 539,000 reading is in the bottom half of the historic range of 400K-800K. In fact, if we ignore recessionary periods (shaded areas), new home construction has not been this low since the 1960s when the US population totaled under 200 million vs. about 320 million now and when household size was larger than it is today.

It is true that multi-family construction is now more prominent than in the past and that it mitigates the sluggishness in single-family construction. As seen below, multi-family housing volumes now exceed the high preceding the 2008 crisis.

Screen Shot 2015-03-24 at 11.04.43 AM (2)

But if we use a back of the envelope approach and use a figure in the low 300,000 multi-family annual units as an historic average, we could say that the last multi-family reading is about 150,000 units above average. We could then argue that these 150,000 were ‘shifted’ from single-family homes. (That may be a generous assumption, considering that a large share of these multi-family buildings are destined to be rentals. Nonetheless the higher demand for rentals can also be considered a secular ‘shift’ that should be counted.)

Without this shift in living preferences, we could then argue that single-family sales would have been about 150,000 higher and closer to a 700,000 annual pace. That is a much better figure than 539,000 but still not very robust compared to the past, given low interest rates, the growth in population and the decrease in household size. In my view, keeping these factors in mind, an adjusted figure north of 800,000 single-family units would be closer to the historic norm. We should therefore be looking for a monthly report of at least 650,000 single family homes before we can talk about a return to normal.

In US Housing and Demographics, I made an argument three years ago that the housing market would be weak until at least 2020 because of adverse demographics. So far, it looks like the recent data supports my thesis. Homebuilder stocks have risen since then. This is based in part on optimistic anticipation of greater home sales, and in part on the fact that homebuilders have been quite adept at identifying and directing their efforts at higher growth areas of the country.

 

Ratio of Gold to S&P 500

6 March 2015

by SAMI KARAM

The ratio of the price of gold to the S&P 500 shows two notable extremes, which are made evident by the log-scale chart below. The first was a reading of 6.1 in January 1980 when gold spiked up to $850 per ounce and the S&P 500 was struggling to shake off the 1970s syndrome of “death of equities”, “misery index” and “malaise”. The second was 0.19 in July 1999 and subsequent months when gold hit a multi-decade low of $252.8 while the S&P 500 soared on the wings of the Nasdaq bubble.

A more recent high of 1.5 was in September 2011 when gold reached an all-time high of $1,895. The ratio has since retreated to 0.56 today which is a level not seen since the stock market highs of 2007.

(click chart to enlarge)

Sources: Kitco, S&P, populyst.

Sources: Kitco, S&P, populyst.

It should be noted that the average for the ratio, since gold started trading freely in 1968, is 1.18, which means that it is now well below the average. Reversion to the mean here would mean the S&P 500 falling by half or gold doubling, or various combinations such as for example the S&P 500 falling by 35% while gold rises 35%.

There is no doubt that there is some exuberance in the stock market, but it does not necessarily follow that the ratio should quickly revert to its long-term average. After all, one may ask, why is this ratio even relevant? It is a question that is justified if you believe that gold should only reflect inflation expectations. Then it would rise or fall with inflation fears.

But in reality, there is more complexity in what drives the price of gold. Inflation numbers were similar in the 1990s and 2000s but gold fell in one decade and rose in the other. Therefore, inflation alone is not enough to explain its behavior.

What drives the price of gold will be the subject of another post. But here it is enough to say that it is driven in part by several factors which are the inverses of those that drive the S&P 500. It makes sense therefore to keep an eye on the ratio.

The Case for Agricultural ETFs: A Conversation with Sal Gilbertie

23 February 2015

(also published on Seeking Alpha)

by SAMI KARAM

“It is really important to have ags in your portfolio. Most people have gold and most people have oil. The fact that they don’t have ags is actually quite a mystery.”    Sal Gilbertie, President of Teucrium Funds.

As Sal Gilbertie would have it, CORN is not only the king of agricultural commodities. It is also the ticker symbol for one of Teucrium Funds agricultural ETFs. In addition to CORN, Teucrium offers three other single-commodity ETFs: WEAT, SOYB, CANE, for wheat, soybean and sugar. Each of these ETFs invests in futures and is configured to “mitigate contango and backwardation” and to track the price of its underlying commodity. A fifth ETF, with ticker TAGS, tracks an equally-weighted basket of corn, wheat, soybean and sugar.

I recently had a conversation with Gilbertie who is President of Teucrium. Gilbertie cut his teeth in the 1980s as a commodities trader at Cargill and later at other large institutions. His case for investing in agricultural commodities is three-fold:

  • the long-term: growth in demographic demand in emerging markets.
  • the timeless: diversification away from the S&P 500 and from gold.
  • the short-term: agricultural commodities are now significantly undervalued relative to gold.

1- Long-term Demand and Supply

Demand for agricultural commodities is expected to rise steadily in the decades ahead due to 1) the growth of the global population currently from 7 billion people to over 9 billion by 2050 and 2) the rise in living standards and concomitant improvement in diets in emerging markets.

The table below shows future population estimates per the United Nations’ medium variant estimates. It should be noted that this medium variant assumes a big decline in total fertility rates (TFRs, number of children per woman) in India and Sub-Saharan Africa. In the event that TFRs do not decline as fast as expected, the population growth in these countries would be even greater.

Asia and Sub-Saharan Africa will show the biggest jump in population and in demand for basic food stuffs. Note in the table that Sub-Saharan Africa is forecast to contribute half the population growth between today and 2050, and as much as 81% of the growth between today and 2100.

Screen Shot 2015-02-20 at 5.53.58 AM

 

It is not difficult to conclude from these figures therefore that Sub-Saharan Africa will require more than a doubling of food supplies in the next 35 years, a significant challenge at a time when it is still trying to eliminate hunger in many countries.

Of course, supply is also growing but it is generally more volatile than demand due to periodic crop failures (from floods, droughts etc.) in one or another region of the world. Supply is also constrained by two factors: lower yields from farms in emerging markets and poor infrastructure in the regions of the world which have the largest unused acreages of arable land.

In 2012, the African Union Commission (AUC), the United Nations’ Food and Agriculture Organization (FAO) and the Brazil-based Lula Institute joined forces to “eradicate hunger” in Africa. At the time, the Chairperson of the AUC stated the following [my emphasis]:

“Food security is one of the key priorities of the African Union. Africa has the potential to increase its agricultural production given that almost 60 percent of the arable land in the continent is still not utilized. This enormous potential can make a real difference to improve our agricultural production and food security. It is time to move beyond subsistence agricultural production and consider ways of eventually embarking on agro-industrial production.”

More generally, looking at the global picture, Sub-Saharan Africa is believed to have the largest reserves of untapped arable land. As promising as this may be, massive investments in technology, infrastructure and logistics will be needed before new farm land can yield significant amounts of grain that can be delivered to consumers.

With regards to agricultural yields, an FAO report released in 2002 stated:

“Global cereal yields grew rapidly between 1961 and 1999, averaging 2.1 percent a year. Thanks to the green revolution, they grew even faster in developing countries, at an average rate of 2.5 percent a year. The fastest growth rates were achieved for wheat, rice and maize which, as the world’s most important food staples, have been the major focus of international breeding efforts. Yields of the major cash crops, soybean and cotton, also grew rapidly.”

For example, wheat yields in developing countries have nearly tripled from 1,000 kilograms per hectare in 1968 to over 2,600 now.

To sum up, supply will keep up with demand but only if yields improve at existing farms and if new infrastructure is put in place to service new arable land.

2- Timeless Diversification

Agricultural commodities are less correlated to the stock market than gold and should therefore be considered for diversification at any time. In recent decades, gold has drawn tens of billions in portfolio investments mainly because it was seen as a hedge against possible dislocation in financial markets.

Screen Shot 2015-02-20 at 3.57.31 PM

Gold delivered on its promise as an effective diversification asset in 2008-2011, outperforming stock markets by a wide margin during the financial crisis and its aftermath. Although it has retreated from its 2011 highs in recent years, gold is still a significant outperformer of all leading stock indices in the decade and a half since it hit bottom in 1999. See chart above.

Of course, gold grossly underperformed stocks in the 1990s, but the subsequent decade proved that there can be prolonged periods of time when it beats the popular indices by a very significant margin, notwithstanding comments by some market participants who deride it as barbaric or uncivilized. The pragmatic reality is that, barbaric as it may be, gold sometimes outperforms stocks for ten or fifteen years.

Screen Shot 2015-02-20 at 2.47.14 PM

Still, if we have shown that diversification into commodities is desirable, the chart above from Teucrium’s web page argues that agricultural commodities are even better diversifiers than gold because they have a lower historical correlation with the S&P 500 than gold does. Through the 20-year period 1995-2014, sugar, corn, wheat and soybean have all had a lower correlation to the S&P 500 than has gold.

3- Short-term Valuation

The ratio of gold to corn was in September 2014 at its highest level since gold started trading freely 38 years ago. It stands today at nearly twice its long-term average. Gilbertie says that, on average since 1976, an ounce of gold has purchased 165 bushels of corn. Last September, an ounce of gold could buy 377 bushels and today it can buy around 300 bushels, still nearly twice the long-term average.

The ratios of gold to the other grain commodities and to sugar tell a similar story.

Screen Shot 2015-02-20 at 5.27.15 AM

Thank you for reading. My conversation with Gilbertie includes more original insights about the mechanics of trading futures and ETFs and about the supply and demand prospects for agricultural commodities.

You can listen to the full podcast here:

Disclosure: The author has no contractual agreement with Teucrium and receives no compensation from Teucrium. As of the date of this posting and for at least the following 72 hours, the author has no investments in the Teucrium Funds.

Disclaimer: This article represents the author’s best faith efforts at presenting true facts. Nonetheless, despite the author’s best diligence, the article may include unintentional errors. Do your own work, read more research and draw your own conclusions before you decide to trade.

The BRIC and I

12 January 2015

The growth prospects of Brazil, Russia and China are dimming, while those of India are flaring.

If one is a lonely number, then ‘I’ could be a lonely letter, at least when it comes to the ‘I’ of the BRIC countries. Brazil, Russia and China all face mounting challenges in 2015 but the road ahead seems wide open for India. The main concern with this opening statement is that it seems to be the view of a large majority of observers.

Still, a majority is not the same as a consensus and certainly not the same as an extreme consensus. In investing, the consensus view is often right but the extreme consensus is absolutely and always wrong. For example, the consensus to buy tech stocks in 1997 was right but the extreme consensus to sell all non-tech and buy only tech in early 2000 was very wrong. When it comes to India, we are with the majority view, edging into consensus territory, but still far from extreme consensus. There remain enough doubters to ensure that this story still has plenty of time to play out.

Our approach to the topic is resolutely from the point of view of demographics. Demographics are not the be all and end all of an economy, but they are a very important vector, one of three very important vectors, the other two being innovation and institutional strength. Looking at the BRIC countries, the demographics of Russia and China are poor and those of Brazil are neutral. By contrast, the demographics of India, though challenging due to the large population size, could hold much promise if this huge newly created human energy can be harnessed and channelled in the right directions.

In general, the best demographic profile for an economy would be a rising population coupled with a declining dependency ratio (the ratio of dependents to workers). The increase in population means that demand for goods and services continues to grow. And the declining dependency ratio means that there is plenty of discretionary capital for consuming and for investing.

The US, Europe and China were in this sweet spot until six or seven years ago. Indeed, much of the world was in this sweet spot, a fact which largely explains the enormous creation of wealth and improvement in living conditions for billions of people in the past few decades. Things got more challenging in the middle of the last decade when dependency ratios in several countries bottomed out and started to rise.

BRIC Countries Total Dependency Ratios

BRIC Countries Total Dependency Ratios

We can’t blame the 2008 crisis on demographics alone. There were many abuses and excesses in the system which brought about the crisis. But it is worth noting that the crisis struck about the same time that a big reversal in demographics was taking place. A crisis would have come any way but instead of 2008, perhaps it would have come in say 2012 if the dependency ratio had bottomed four years later than it did.

Nor should anyone be surprised that Japan peaked in the late 1980s and has been struggling since then. Its dependency ratio bottomed in the early 1990s.  Or that China saw a huge boom since 1980 after it introduced its one-child policy, thus engineering a very steep decline in its dependency ratio. Or that the US recovery has been slow, given that its population growth has slowed down and its dependency ratio has been rising.

USA, Europe, Japan Total Dependency Ratios

USA, Europe, Japan Total Dependency Ratios

As shown in the first chart above, India is the only BRIC country with a declining dependency ratio between now and 2030. Russia and China’s are already rising and Brazil’s will bottom and rise by the end of this decade. Russia seems to be in the worst shape since it has both a declining population and a rising dependency ratio.

Finally two quick words on the other big vectors of economic growth: innovation and institutional strength. Innovation in Brazil, China (ex-Taiwan) and Russia has been slow and cannot be considered a factor in future growth. There was plenty of excess capital to invest in new businesses when the dependency ratio was declining in all those countries but it went instead into real estate and other unproductive investments. Innovation has been slightly better in India and could take a big leap forward with more capital investments in the decades ahead. India also has an immeasurably greater competitive advantage compared to the other BRIC members: its population speaks English.

Institutional Strength can be the subject of endless debate, especially if we try to draw comparisons across countries. All emerging countries have to make significant progress on this account.

When Will Oil Bottom?

8 January 2015

Not until the discount of WTI to Brent disappears.

If one of Saudi Arabia’s objectives is to curtail American shale oil production, then it bears to reason that this objective will not be attained until Brent and WTI trade at parity once again. In recent years, the surplus production of American oil coupled with the legal ban on US oil exports has resulted in a discount of WTI vs. Brent. Going forward, there will be no incentive for a domestic oil buyer to replace US oil (WTI) with foreign oil (Brent) as long as the first is at a discount to the second.

Regardless of the prevailing price, US shale oil production will continue to grow through this year; many wells have already incurred their upfront costs and need the cash flow from production to recoup those costs. When oil was flying high near $100, these operating cash flows were expected to widely offset the upfront costs and to generate an attractive total return for the venture. Now with oil near $50, many will not generate a positive return but they still need the cash flows to get as close as possible. Despite a declining price, there is therefore an incentive to keep pumping for as long as possible.

In theory, at current prices, shale production growth will taper off and could even reverse after a few years. This at least is OPEC’s calculation. Markets discount the future and OPEC’s current price war cannot be judged a success until the WTI discount to Brent has disappeared.

It appears on its way to doing so, having fallen from a high of $9 and a 2014 average of about $6 to little over $2 today (see chart).

WRIBrent20150108

It is a fair assumption that the discount will continue to shrink if the price of oil continues to fall. At $40 or $30, it may disappear completely, But at those levels, there will be other unforeseen consequences. For example, if the US economy weakens due to job losses in Texas and North Dakota or due to more weakness overseas, there would be less demand for oil, resulting in another domestic oil glut and another widening of the discount. Stay tuned.

Oil20150108

Top 10 Populations in 1950, 2013 and 2050

16 December 2014

A useful chart from The Economist relaying the same information that we posted a week ago. Note the absence of European countries from the 2050 list.

See also Demography Charts – 1 and Demography Charts – 2

Top10Pop

 

Demography Charts – 2

9 December 2014

See also Demography Charts – 1

Below are lists of largest country populations in 1950, 2015 and 2050, assuming the UN’s medium-variant projections. Key takeaways:

  • Lower growth for world population in upcoming decades as total fertility ratios (TFR = children per woman) decline in Africa and Asia.
  • Four European countries were in the top 10 in 1950. Only one (Russia) remains in 2015 and none in 2050.
  • US population drops from 6.3% of world in 1950, to 4.4% in 2015, to 4.2% in 2050.
  • Huge increase in Sub-Saharan Africa from 2015 to 2050, despite an expected decline in TFR.

Top 10 populations in 1950:

Population (millions) 1950
WORLD 2526
Sub-Saharan Africa 179
China 544
India 376
United States 158
Russia 103
Japan 82
Indonesia 73
Germany 70
Brazil 54
United Kingdom 51
Italy 46

 

Top 10 populations in 2015:

Population (millions) 2015
WORLD 7325
Sub-Saharan Africa 949
China 1401
India 1282
United States 325
Indonesia 256
Brazil 204
Pakistan 188
Nigeria 184
Bangladesh 160
Russia 142
Japan 127

 

Top 10 populations in 2050:

Population (millions) 2050
WORLD 9551
Sub-Saharan Africa 2074
India 1620
China 1385
Nigeria 440
United States 401
Indonesia 321
Pakistan 271
Brazil 231
Bangladesh 202
Ethiopia 186
Philippines 157

Finally, here is a chart of Europe and Sub-Saharan Africa as percent of total world population.

EuropeSubSaharan

 

 

Oil Quake 2014

2 December 2014

The consequences of a collapsing oil price will be deep and wide ranging. Brent oil has crashed from $115 per barrel in mid June to around $70 today, and WTI from $107 to $66. Here are the likely ramifications, the obvious and the less obvious:

1- Pressure on US shale oil producers: “Tight” shale oil is more expensive to produce than conventional oil. A lower oil price means lower profits for shale producers, or losses in many cases. OPEC’s alleged strategy and gamble are to put some of these people out of business in order to maintain the cartel’s long-term control on pricing. See next two charts.

ShaleBreakeven2

On this, four issues should be considered.

First, the breakeven oil price for shale producers is a moving target. It may be $70 today but it will be lower than $70 in the future thanks to new technology and cost cuts.

Second, the breakeven oil price, for example $70 for a given shale well, includes upfront investments which means that the marginal cost of production is lower. In many cases, this marginal cost is below $40 at wells which are already up and running. After the crash, producers will treat upfront investments as sunk costs and will continue to operate these wells for their attractive cash flows.

ShaleBreakeven1

Third, US law does not allow oil exports from the lower 48 states which means that the shale oil produced in the US ex-Alaska must today be processed domestically. OPEC’s calculation may be that the price of Brent will go low enough to displace domestic US producers, but this looks unlikely as long as there is a discount between WTI and Brent prices. If shale oil production slows down, one would expect the discount to narrow and disappear. In fact, factoring in the cost of transport, Brent would have to trade at a discount to WTI, instead of the current premium, before OPEC’s strategy could be considered a success. WTI is still trading at a $4 discount to Brent today, essentially unchanged in the last two months, albeit lower than it was in the earlier part of the year.

WTI Brent

WTIBrentDiscount 20141201

Fourth, there is some risk of financial turmoil. Several US shale oil producers are highly indebted and will suffer from declining cash flows. Marketwatch has compiled a list of companies that “are in big trouble if oil prices remain low”.

In addition, this article in The Telegraph (which appeared before the latest decline in oil) states that:

“Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20pc to $60 per barrel, it could result in up to a 30pc default rate among B and CCC rated high-yield US borrowers in the industry. West Texas Intermediate crude is currently trading at multi-year lows of around $75 per barrel, down from $107 per barrel in June.

A shock of that magnitude could be sufficient to trigger a broader high-yield market default cycle, if materialised,” warn Deutsche strategists Oleg Melentyev and Daniel Sorid in their report.”

In 2010, energy and materials companies made up just 18pc of the US high-yield index – which tracks sub-investment grade borrowers – but today they account for 29pc of the measure after drilling firms spent the past five years borrowing heavily to underwrite the operations.

In the end, a lower oil price may deter some new shale investments, but it will not, or not yet, shutter existing wells. It is difficult to make a case that $70 per barrel is low enough to significantly alter the shale oil dynamic, unless a large number of companies run into financial distress.

2- Pressure on oil-dependent governments: The outcome here may be the difference between a manageable shock for some, and a much more challenging situation for others. Stratfor has compiled the table below which shows the energy dependence of several government budgets. Countries such as Iran, Venezuela and Nigeria need an oil price well in excess of $100.

In the right column are each country’s financial reserves which are a measure of each government’s firepower to withstand the shock. Budgets with a high breakeven and low reserves relative to their populations will experience greater strain than others. Venezuela and Nigeria appear vulnerable. Russia will also feel pressure but it has larger financial reserves and a falling currency which will dampen the shock internally.

Oilbreakeven

3- Relief for US consumers and manufacturers: The fall in oil and slower fall in gasoline prices are a clear positive for US consumers. Deutsche Bank analysts estimate that every cent decline in the price of gasoline results in $1 billion of annual energy savings in the United States. A one dollar decline would free up $100 billion every year for investing or spending. The Wall Street Journal estimates that, since 2007, Americans have underspent on apparel, household textiles, appliances and real estate, all sectors which stand to benefit from years of pent-up demand.

WSJ chart

More broadly, the US economy will experience a new stimulus from lower commodity prices. All sectors (ex-energy) are beneficiaries but transport and manufacturing companies could enjoy significant windfalls.

Keurig Green Mountain: Overpriced Coffee and Stock

20 November 2014

From a press release on 14 August 2014:

Keurig Green Mountain, Inc. (NASDAQ: GMCR), announced today a price increase of up to 9% on all portion packs sold by Keurig for use in its Keurig® brewing systems and on all its traditional bagged, fractional packs, and bulk coffee products. This price increase will be effective beginning November 3, 2014.

According to Dr. Travis Bradberry, author of Emotional Intelligence 2.0, caffeine boosts your adrenaline level and “adrenaline is the source of the “fight or flight” response, a survival mechanism that forces you to stand up and fight or run for the hills when faced with a threat.”

So Keurig has opted to fight any threat to its margins. It will not be easy.

Until now, Keurig’s profit margins on K-Cups have been very attractive. Profits from the Keurig coffee machines are probably small or nonexistent, which means that the EBITDA margin on coffee alone is higher than the 24% group-wide EBITDA margin. And within coffee, the margin on K-Cups is higher still, which explains GMCR’s 5x price to sales ratio and its $23bn market cap.

The problem going forward is that competition will only increase, putting pressure on market share and on margins. I sum it up through three main headings: K-Cups, Machines and Nestlé.

K-Cups

If you collect enough coffee from K-Cups to fill a one-pound bag, you will have spent anywhere from $25 to $50 in K-Cups. That could be well over twice the retail price of bagged coffee, which itself already enjoys a hefty markup.

Put another way, if I prepare my daily coffee using K-Cups and a Keurig machine, it will cost me anywhere between 60 cents to over a dollar per cup. But if I buy bagged coffee and EZ-Cup Filters, it could cost me say 25 cents for the coffee and 10 cents for the filter, all together about half the less pricey K-Cup option. The bottom line is: coffee sold in K-Cups costs a lot more than the same amount of coffee sold in bags (to do the math, 1 pound = 453.6 grams).

In this photo taken at a coffee shop, the same brand coffee is selling for $13.95 per pound and for $11.95 for a box of 12 K-Cups, each weighing 12.9 grams. Pound for pound, the K-Cup coffee costs 2.5x the bagged coffee. Some premium is certainly justified for processing, grinding and packaging K-Cup coffee, but 2.5x looks like a very generous markup.

This large price difference creates an opportunity which puts Keurig margins at risk. If I were a manufacturer instead of a consumer, I could buy coffee wholesale for less than 25 cents per 10-gram serving (the amount of coffee in most K-Cups appears to be in the 9 to 12 gram range), put this coffee in compatible cups or filters and sell it at a tidy profit while still undercutting Keurig prices. The large Keurig markup means that there is ample room for competitors to enter at various price points and still derive a profit.

None of this has gone unnoticed. As many as 14% of K-Cup compatible pods have come from private-label suppliers (other estimates are closer to 10%). The remaining 86% come from Keurig’s own brands and from Keurig licensees (Starbucks SBUX, etc.). Keurig believes that the 14% will decline and that the 86% will grow. But the opposite is just as likely because competition does not usually decrease when margins are large for a product which is being progressively commoditized.

There will certainly be more competition at lower price points in single serve units whether they are called K-Cups, pods, capsules, or something else. This company for example offers tiny suppliers (as small as individual coffee shops) the opportunity to package their coffee into Keurig compatible cups, starting with very small volumes. Going forward, one could buy single serve cups from Keurig or a Keurig licensee or buy them from a favorite coffee shop at about half the price.

In this vein, I am reminded of an interview with Harvard Professor Clay Christensen in which he discusses Apple’s success within its own ecosystem. You could substitute Keurig for Apple in the following quote and it would make sense:

In the end, modularity always wins… You can predict with perfect certainty that if Apple is having that extraordinary experience, the people with modularity are striving. You can predict that they are motivated to figure out how to emulate what they are offering, but with modularity. And so ultimately, unless there is no ceiling, at some point Apple hits the ceiling.

Granted this is long-term theory. In the near term, as the good times continue, Keurig can be described as a marketing rollup. In a traditional rollup, a company grows by acquiring several of its peers sequentially over a period of years. It brings its expertise and economies of scale to its acquisition targets and benefits from their improved profitability. In a marketing rollup, a company convinces several of its peers to join its platform by promising to sell their product at a higher price and splitting the benefits with them. Keurig has clearly been masterful at deploying this strategy, selling its own and third-party coffee at a premium.

Keurig has also been masterful at announcing new partnerships frequently and methodically, in a way that has so far been hugely beneficial to the stock price. There is a measure of genius in this management who have not only convinced millions of Americans to pay more for coffee in return for some convenience, but who have also convinced investors that new technology can make a huge difference in the erstwhile mundane task of preparing a cup of coffee. This explains why Keurig’s stock is today very near its all-time high.

Machines

A visit to Bed Bath & Beyond’s website shows that there are now several competing single-serve coffee makers on the market. Some of them like Cuisinart, Mr. Coffee and Hamilton Beach use K-Cups. Others like Nespresso use different capsules. You can now bypass Keurig machines and Keurig coffee brands by buying another machine and by using private label cups. You can choose, from a growing number of alternatives, to enjoy a single-serve cup of coffee delivered with the convenience of a K-Cup (or similar pod) without paying the Keurig company a single dime.

The notion that Keurig can reverse this trend is, in my opinion, unrealistic. Still, the company is giving it a good try with the Keurig 2.0 machine. It includes a carafe and some proprietary technology which will only work with Keurig-approved K-Cups. This means that an unlicensed K-Cup does not work in a Keurig 2.0 coffee maker. A key question for the future is whether Keurig’s market share in K-Cups will erode further or whether it will reverse and trend back towards 100%.

I expect that it will erode further. The restrictive Keurig 2.0 is in theory a good attempt to rebuild the walls surrounding Keurig’s ecosystem, but it does not appear to offer the consumer something truly new and exciting. It does offer the ability to brew a single K-Cup and/or larger batches into a carafe but this is something a consumer can already do with a traditional coffee maker sitting next to a K-Cup machine (made by Keurig or someone else).

Keurig says that a large number of US households have not yet switched to single serve and that their main reason for staying away is that single serve machines do not brew large enough batches of coffee. This may sound like circular logic to justify a plateauing in single serve penetration, but Keurig believes that there is a broader target market for a machine that offers the convenience of both the single-serve and the larger carafe bundled in one product. Except for saving a small area atop the kitchen counter (not an issue in most American kitchens), it is not clear what the consumer is getting in the bundled product that he does not already have.

Notwithstanding the above and judging from the stock’s performance, the market seems to have accepted the success of 2.0 as a foregone conclusion. This may be overly sanguine if Amazon reviews are a good indicator. All three Keurig 2.0 machines available on Amazon have consumer reviews below three stars out of five. By comparison, the older Keurig machines have nearly five stars.

Pricing of Keurig 2.0 machines may be an important determinant of success and needs to be low enough to be competitive with the alternative, which is to own two machines (one single serve, one carafe) for less money and with fewer restrictions than the Keurig 2.0 bundle.

Nestlé

In theory, Keurig has a large potential for expansion outside North America. Today, Keurig’s revenues come from the US and Canada. But the company has recently started to expand into foreign markets, beginning with the United Kingdom. Yet, nothing is as easy outside one’s own home turf. It is not uncommon for a growth consumer company to stumble soon after its entry into a foreign market. In addition, by going overseas, Keurig is entering a world dominated by the giants of global coffee, Nestlé and Mondelez.

They too have ambitions beyond their largest markets. Nestlé is redoubling its efforts in the US. The Swiss company is the world number one in coffee with 22.7% market share, in part because most of the world drinks instant coffee where the Nescafé brand is dominant.

GMCR

Nestlé is already present in single-serve coffee with its Nespresso machines and capsules. Nespresso is dominant in Europe but, in the US, it has lagged Keurig by a long mile because it was slow to adapt to American preferences. Compared to Keurig, Nespresso machines have had higher retail prices and, in the past, have served smaller cups of coffee which are more suitable to the European taste. Although Nespresso has introduced newer machines which can make espresso and larger cups of coffee, it still does not appear to have a product in the US that is designed to take Keurig head on. That could change soon if it is serious about gaining significant share.

We can be confident that competition will intensify here and overseas. But what is of greater importance is the current debate on open vs. closed systems. An open system allows other coffee brands on your machine (for example Starbucks, Dunkin Donuts etc). A closed system does not.

As discussed above, Keurig allows a large number of licensees and a wide portfolio of non-Keurig coffee brands on Keurig machines, all of which bolster the case that Keurig offers an open system. A truly open system however would allow other coffee brands on the machine without extracting a fee from them. So Keurig can be called semi-open (or semi-closed), or open only to the extent that it can obtain a fee from third parties.

Nespresso has been even more restrictive, allowing only Nestlé coffee capsules on its machines. But Nespresso recently lost a ruling in France which forced it to open its machines to other capsule makers. France is Nespresso’s most important market and if Nestlé has accepted that it will run a completely open system in France, it is likely that it will run an open system everywhere. What this means is that there will be more coffee companies making capsules for Nespresso machines. More importantly, it could also mean that these companies can do so without being licensed by Nestlé. If this new openness migrates to the US, it will result in a new headache for Keurig which is trying to remain semi-open (or semi-closed) through its licensing policy and the proprietary technology of Keurig 2.0.

From the point of view of the consumer, a completely open system makes the most sense because it will lead to greater choice, greater competition and lower prices. And as we have seen, prices are high enough that they can fall significantly and still deliver a profit.

Because of its global footprint and large portfolio of brands in other categories, Nestlé could likely sustain pricing pressures in US coffee for longer than Keurig could. Nestlé’s annual coffee revenues dwarf Keurig’s ($16 billion vs. $4.5b) but they amount to less than one fifth of total Nestlé revenues. This is where a large global player like Coke could be helpful to Keurig. But the question remains how much Coke should pay for the rest of Keurig? And when should it make its move?

Coke and Keurig

Keurig stock has been one of the best performers in 2014, in large part due to bid speculation surrounding Coke’s acquisition of a 16% stake in the company. While it is very probable that Coke will eventually buy the rest of Keurig, it does not follow that such a bid is imminent. It could come next week or it could come years from now. Here are the three main scenarios:

1. Coke makes a move fairly soon and offers only a small premium or no premium, arguing that the stock has raced 50% from $80 to $120 and beyond after the acquisition of its initial stake. In other words, the premium is already included in the current stock price.

2. Coke makes a move in a few weeks, months or years at a higher price. By then, the performance of Keurig stock will be largely justified by its own operations and Coke will have to offer a premium to the then stock price. So say that by then the stock is at $170 and Coke will have to offer $200+.

3. Coke makes a move in a few weeks, months or years at a lower price. This could occur if Keurig’s results deteriorate and the stock falls back towards $80 before the bid.

Although investors are excited about scenarios 1 and 2, a trade buyer would normally prefer scenario 3. Why pay $200 per share when you can pay $80 instead? That $120 difference amounts to a $19 billion difference on the current share count.

In February, Coke could have easily bought all of Keurig, given that Coke’s market cap was then over twelve times the market cap of Keurig. The fact that it did not bid on all of Keurig outright could suggest that it viewed the stock as overvalued. Or it could suggest that it needed more time to get comfortable with the prospects of Keurig Cold.

With a choice to act now or wait longer, it may be wiser for Coke to wait longer given the mounting uncertainty facing Keurig. In addition to the competitive challenges discussed above, rising coffee prices could exert further pressure on margins.

Severe droughts in Brazil have resulted in the price of Arabica coffee soaring from $1.10 to $2.10 per pound in the six months to May 2014. It then dipped to $1.60 in June as suppliers sold down their inventories. But the depletion of these inventories boosted the price back to near $2 as of now. The onset of a new El-Nino effect has some predicting a further increase to $3 per pound. Keurig is hedged for 2015, but at higher prices than for 2014. As noted above, it will try to pass on some of these increases to consumers but from $30 per pound equivalent for K-Cups, it is not clear whether consumers will accept the increase or migrate to lower-priced private labels in greater numbers.

Keurig’s rich pricing and margins are not sustainable in the face of rising competition from Nestlé and private label suppliers. Keurig’s management have done an excellent job bringing the company to where it is today. But competitive pressures are mounting and a full bid from Coke is already priced in. At 20x 2015 EBITDA, the stock looks stretched.

This article only represents the author’s opinion, may include unintentional errors, and is not meant to influence the reader’s decision to trade Keurig stock long or short. Do your own work, read more research and draw your own conclusions. If you short the stock, you should be cognizant that 1) Keurig has been very adept at boosting its stock price despite declining revenue growth and 2) a full bid from Coke could come at any time.

Demography Charts – 1

13 November 2014

Below are charts of country and regional dependency ratios.

First some definitions:

The total dependency ratio is the ratio of the population aged 0-14 and 65+ to the population aged 15-64. They are presented as number of dependents per 100 persons of working age (15-64).

The child dependency ratio is the ratio of the population aged 0-14 to the population aged 15-64. They are presented as number of dependents per 100 persons of working age (15-64).

The old-age dependency ratio is the ratio of the population aged 65 years or over to the population aged 15-64. They are presented as number of dependents per 100 persons of working age (15-64).

The charts below are derived from the United Nations’ World Population Prospects – The 2012 Revision

In theory, the economy does better when the dependency ratio is falling and less well when it is rising. But, as discussed in this previous post, two important mitigating factors are a country’s rate of innovation and its institutional strength, .

United States, Europe, Japan

Figure 1 shows the total dependency ratios of Europe, Japan and the US from 1950 to 2050.

Total Dependency Ratio

Fig. 1. Total Dependency Ratio, Europe, Japan, USA

Key takeaways are:

  • The ratio bottomed in Japan two decades before it bottomed in Europe and the US, which may explain Japan’s stagnation relative to the US and Europe in the 1990-2008 period.
  • In the 1980s, 1990s and early 2000s, Europe and the US benefited from a declining ratio.
  • All three ratios will rise from now into the foreseeable future. But Japan’s ratio will rise faster due to its older population.

BRIC countries

Figure 2 shows the total dependency ratios of the BRIC countries: Brazil, Russia, India and China.

Fig. 2. Total Dependency Ratio

Fig. 2. Total Dependency Ratio, BRIC countries

Key takeaways are:

  • The ratios of Russia and China are both bottoming in the middle of the present decade and will rise for the foreseeable future.
  • Brazil’s ratio will bottom later this decade and will subsequently rise.
  • India’s ratio will continue to fall until about 2030 and will level off until 2050, which may help its economy grow faster.

Country Charts

Following are charts for a few individual countries and for Europe and Africa, showing all three dependency ratios as defined above. The blue line is the total ratio, the red is the child ratio and the green is the old-age ratio.

DR United States

Fig. 3. Dependency Ratios, USA

In the case of the US, Europe, Japan and China, it is clear that the rise in the total dependency ratio is mainly driven by a rising old-age ratio. Japan has the fastest rising old-age ratio. None of these countries is expected to see a big rise in its child ratio.

DR Europe

Fig. 4. Dependency Ratios, Europe

 

DR Japan

Fig. 5. Dependency Ratios, Japan

Note the steep 40+ point decline in China’s total dependency and child dependency ratios between 1970-2010. It is due to the country’s one-child policy and it provided a big boost to the Chinese economy in recent decades.

DR China

Fig. 6. Dependency Ratios, China

The following chart compares the total dependency ratios of the US and China. China’s ratio fell faster and will also climb faster.

Fig. 7. Total Dependency Ratio, USA, China

Fig. 7. Total Dependency Ratio, USA, China

India and Sub-Saharan Africa have a more promising demographic profile. A declining total ratio could markedly improve their economies, if other obstacles can be overcome. In addition, unlike other regions, Sub-Saharan Africa will not have a rising old-age ratio for the foreseeable future.

DR India

Fig. 8. Dependency Ratios, India

 

DR SubSaharan

Fig. 9. Dependency Ratios, Sub-Saharan Africa

 

DR Russia

Fig. 10. Dependency Ratios, Russia

 

DR Brazil

Fig. 11. Dependency Ratios, Brazil